Time Running Out On Roth Break

YOUR MONEY

Converting Before '99 Should Pay Off Later, But Make Sure You're Prepared For Tax Bill

November 22, 1998|By Chicago Tribune

CHICAGO - To convert or not to convert? That is the question bearing down on owners of individual retirement accounts as the deadline approaches on a tax break for conversion of conventional IRAs to Roth IRAs.

Awareness - and angst - are bound to grow as financial-services companies push ahead with ad campaigns urging action by year-end, when the tax break dies.

Does it pay to make a switch?

Sometimes it pays, experts say, but the decision will require analysis, some educated guesswork and the ability to stomach an upfront tax bill.

``It can be beneficial as long as you have the intestinal fortitude,'' said Mark Bell, a financial planner based in Chicago.

The prime benefit: Money invested in Roths, although not tax-deductible, grows tax-free, and future distributions are tax-free as long as certain conditions are met. This means any gains on underlying investments - be they mutual funds, bonds, certificates of deposit or what have you - are free from federal income tax.

With a conventional IRA, in which contributions often are tax-deductible, income taxes are deferred but must be paid when distributions are taken during retirement.

Calling the Roth ``a powerful wealth-builder,'' Nick Kaster, a senior analyst at tax-law publisher CCH Inc., said, ``There is no other tax vehicle like the Roth for average people.''

That message appears to be resonating with individual investors. Financial-services companies across the country report significant upticks in IRA activity since the Roths became available Jan.1 for the 1998 tax year.

But although the decision to open a Roth with new funds may be a relative slam-dunk, particularly for higher-income investors who do not qualify for deductible IRAs, the decision to convert an existing IRA to a Roth is more difficult.

The biggest hurdle: An investor must pay income tax on the taxable portion of an existing IRA before switching the money to a Roth. The taxable portion consists of any contributions for which tax deductions were taken and all earnings.

To ease the pain, the U.S. government - which stands to benefit from early tax payments - is offering a tax break for those who convert before year-end. Those who convert can spread the tax bill over four years, rather than having to pay it all in one year, as they will have to do after this year.

When weighing whether to convert - an option open only to individuals and couples with adjusted gross incomes of less than $100,000 - there are several major factors to consider, planners say:

Paying the tax bill. If you have the money to pay the taxes without dipping into your IRA, great. In effect, you would be adding to your tax-sheltered nest egg beyond the $2,000-a-year contribution limit.

But if you have to deplete your IRA to pay the tax, conversion ``doesn't make sense,'' said Steven E. Norwitz, a spokesman for T. Rowe Price Associates Inc.

Assessing your investment horizon. The longer you can keep your money in the account after conversion, the more attractive conversion becomes, said Kaster of CCH. The idea is to let the money grow enough to offset your tax cost and to build additional wealth. The higher your expected rate of return, the more appealing a Roth becomes, T. Rowe Price points out.

Still, ``before you convert, you should hope to keep the money invested at least 10 years, and then to take it out over at least another 10 years,'' Norwitz said.

Generally, if you are younger than 591/2, withdrawals made less than five years after conversion are subject to penalties.

One compromise is to consider a partial conversion, said Gobind Daryanani, author of the Roth IRA Book: An Investor's Guide. If you are nearing retirement, for example, decide how much money you'll need in the next few years, and leave that in your existing IRA; then convert the rest.

Predicting your future tax bracket. Conversion may make sense if your tax bracket will be the same as it is now, or higher, when you begin taking distributions from your IRA, generally a viable option after age 591/2.

But if you expect a significant drop in your tax bracket, which is not uncommon in retirement, there's no point in paying taxes now.

Essentially, this is an exercise in crystal-ball gazing, particularly because no one knows what Congress may do with tax rates in years ahead, Kaster said.

Sizing up your sea legs. ``The person who converts has to be very comfortable paying taxes upfront on a balance that may diminish dramatically over the next couple of years,'' Bell said.

Many investors already have felt this pain in the shorter term, including Cindy Johnson, 40, a first-grade teacher who lives in Willowbrook, Ill.